Demanding that governments take fiscal responsibilities seriously is all very well but we already know from the UK experience that golden rules tend eventually to turn to base metal. And even if countries were to behave themselves fiscally, there is no guarantee that they would enjoy lasting economic and financial stability. Good fiscal behaviour can still be associated with huge imbalances and massive economic dislocation.
For the most part, the Chinese have recycled their excess savings into US assets, primarily via their ever-rising foreign exchange reserves. Over the last decade or so, this led to tremendous demand for Treasuries, pushing yields to extraordinarily-low levels. Private investors looked elsewhere for higher returns, leading to a massive rise in demand for mortgage-backed securities that ultimately paved the way to the sub-prime crisis.
The eurozone deal will fail because it offers no explanation of how, precisely, the German current account surplus will be recycled if the southern European nations head down the path of fiscal righteousness.
Maybe, in their dreams, European policymakers hope the German surplus will come down of its own accord. In reality, however, there are only two ways in which the surplus can decline: Either German exports have to fall relative to imports, or imports rise relative to exports.
The first of these options will most likely occur should southern Europe succumb to deep recession. Taken together, Italy and Spain are a more important destination for German exports than the US. Fiscal virtue in the south is all very well but the collateral damage associated with ongoing austerity will eventually hurt Germany and other northern European exporters. It’s not something anyone would seriously wish for.
The second option will only happen if Germany accepts the need to boost domestic demand growth over and above what we’ve seen in recent years. If, however, demand is higher, there’s a good chance that German inflation will also be higher.
For the eurozone as a whole, that would be a good thing: lower-than-average inflation in the southern nations accompanied by higher-than-average inflation in Germany and other northern eurozone nations would allow competitive adjustments to take place without the threat of a descent into deflation in aggregate. While it’s a neat solution, it’s not obvious that Germany, with its hatred of inflation, will play ball.
And what if neither balance of payments adjustment option transpires? How, then, would Germany recycle its savings? While investing elsewhere in the world remains a possibility, Germany has shown in recent years that it prefers to keep its investments mostly within the eurozone, opting for the “safety” of investing in a common currency.
If, however, southern European nations are no longer in the business of issuing unlimited government paper, what other assets might German investors acquire? Perhaps we’ll see the titans of German industry building new factories in Spain, Portugal or Greece. But Germany’s excess savings might be invested in southern European real estate or, even worse, newly-created pieces of paper uncannily similar to mortgage-backed securities.
Countries which have virtuously delivered fiscal surpluses have, too often, succumbed to financial crisis. In the late-1980s, the UK ran a budget surplus alongside a current account deficit. Only as the economy began to collapse did policymakers begin to recognise that imbalances within the private sector could be just as damaging as those within the public sector. The UK economy wilted in the face of a rapidly deflating housing bubble.
Then there was Asia in the mid-1990s. For years, policymakers argued in favour of a continued Asian miracle as a result of fiscal prudence accompanied by private sector endeavour. Following the Thai baht crisis, we suddenly learnt all about crony capitalism. It turned out that achieving a fiscal surplus was no guarantee of lasting economic health.
Even if eurozone countries achieve fiscal salvation, they may still find themselves succumbing to economic and financial crises. Until and unless Germany’s current account surplus comes down, the risk of repeated crises will remain very high. The fiscal compact so desired by northern European nations may eventually come through. It is, however, not the right answer. That’s because no one in eurozone policymaking circles bothered to ask the right question.
Stephen King is group chief economist at HSBC and the author of Losing Control (Yale)